What is a stock market crash and why do they happen?
Rebecca Cattlin October 18, 2021 7:00 PM
When shares drop dramatically across most constituents of an index, this is called a stock market crash. But it does not necessarily foretell a long-term decline. Read on as we explain more about a stock market crash.
Looking for something specific? Skip ahead to a section of this article using the links below:
- What is a stock market crash?
- What causes a stock market crash?
- Will the stock market crash soon?
- What happens if the stock market crashes?
- What to do in a market crash
- Stock market crashes in history
What is a stock market crash?
A stock market crash is a sudden, and dramatic, decline in stock prices across the majority of a stock market. A huge surge in investors selling their shares pushes the prices down further and further, which can result in large losses, and even lead to a significant bear market or recession.
There’s no set definition of a stock market crash, but typically the market would have to fall by more than 10% from its 52-week high over a few days or even weeks to be considered.
Famous stock market crashes include the 1929 Great Depression, Black Monday 1987, the burst of the 2001 dot-com bubble, the Great Recession of 2008, the 2010 flash crash and the 2020 Covid-19 crash.
To get an idea of the depth of a stock market crash, most traders will watch indices that track the overall market, such as the S&P 500 and Nasdaq 100 in the US, and the FTSE 100 in the UK. When you look at the price chart for an index amid a crash, you’ll see the share price literally nosedive, hence the term ‘crash’.
Here’s an example of the Dow Jones Industrial Average Index in March 2020 when it fell by 37% between February 12 and March 23 – this included some of the worst daily percentage declines in history, such as on March 16 when it fell by 12.9% causing trading to be suspended multiple times.
What causes a stock market crash?
A stock market crash is primarily caused by the combination of falling demand and panic selling. Crashes typically happen at the end of a long bull run, or a bubble, which occurs when investor optimism leads to overvalued share prices. Once investors perceive that an asset has reached its peak value, they’ll start to sell the stock in an attempt to get out before the market falls and they take on extreme losses.
As all market prices are based on the perceived collective value of a company, all it takes is just one large sell order to spark the sell-off and induce panic among other investors. Then before you know it, everyone is trying to sell their stocks and creating the crash they feared.
Will the stock market crash soon?
Talk of an imminent stock market crash has been brought on by speculation that the Federal Reserve will start tapering off its quantitative easing programme – meaning it will be buying fewer assets – and the damage to supply chains caused by the pandemic.
With more government spending, we’ve seen an increase in inflation, which has led to investors being cautious. When interest rates are low, as they have been since the start of the global pandemic, inflation is known to increase – couple this with reduced consumer spending and it could cause a recession. Speculation has therefore increased that the Fed is likely to reduce its QE program to reduce inflation. This can lead to ‘taper tantrums’ which causes share and bond prices to fall.
As for supply chains, car manufacturers were some of the first to take a hit as the shortage of microchips out of Asia caused a decline in production and led to weaker sales. And more recently, we saw a huge spike in petrol prices in the UK after supply issues caused by HGV driver shortages caused panic buying at the pumps.
The S&P 500 has traditionally done poorly in September and October, which has always created concerns that a stock market crash is more likely over those months. However, past performance is not a sure indication of future results.
It’s important to remember that no one is going to be able to 100% predict if the market will crash in 2021, so all you can do is keep monitoring the markets and try not to panic.
What happens if the stock market crashes?
If the stock market crashes, there is usually a lasting impact on the economy, such as a recession. As stocks are a viral source of capital within the economy, corporations may struggle to grow if investment falters. This means that businesses may have to lay off workers, who will then spend less, and the economy will become stagnant.
As we know, stock market crashes also cause significant losses for individual investors. This can happen either as a result of selling their shares when the market has fallen or having bought shares via derivative products. It’s important to remember that corrections are part of the market cycle, and although they can induce panic, prices will often recover over time.
As a result of the damage that can be caused, there are a variety of measures that have been put into place in order to lessen the impact of crashes, such as circuit breakers or trading curbs. These safeguards prevent any trading activity over a set period of time, which is intended to stabilise the market and prevent any further declines.
For example, the New York Stock Exchange will halt trading if the S&P 500 declines in price in the event it hits any of the three circuit breakers set at 7%, 13% or 20%.
Another means of protecting the market is called ‘plunge protection’. This is when large organisations step in and purchase large quantities of shares in the hopes of encouraging individuals to continue investing. This method is less effective, however.
What to do in a stock market crash
What to do in a stock market crash will largely depend on what your strategy is: are you a long-term investor or short-term speculator?
For investors, it can be tempting to panic with the rest of the market and sell. A stock market crash will reach a bottom eventually, at which point it’ll bounce back, and you could regret selling your position and taking on a loss. If you sell, you’ll likely be unable to buy back at a price that would enable you to recoup all your losses.
So, if you can’t sell before the crash – which even the most sophisticated investors fail at – your best bet is to maintain a diversified portfolio at all times. This way, in the event of a sell-off, you haven’t put all your eggs in one basket and will hopefully be able to maintain a level of profit.
You may also want to look at hedging your portfolio. Certain asset classes rise in periods of economic downturn, whether they’re defensive stocks that remain stable throughout market cycles or safe havens, they could provide a way of off-setting your losses. For example, gold is a popular hedge against a stock market crash, as frequently prices rise as investors look for a more stable store of value.
For traders, a stock market crash can be an exciting – but risky – time. Using derivative products enables you to take a position that’s traditionally more difficult: going short. When you short a market, you’ll make a profit if the price declines and a loss of it rises. So, shorting stocks amid a crash can create an avenue of profit for speculators, but in such a volatile and unpredictable environment, you’ll need to make sure your risk management measures are solid.
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Stock market crashes in history
There have been a huge number of stock market crashes throughout history, purely because they are a natural part of the cycle. So, let’s take a look at some of the most recent and most famous examples.
1. Stock market crash 1929: The Great Depression
As the economy grew in the 20s, spurred on by post-war optimism and advancements in technology, the stock market expanded rapidly. The companies behind these inventions saw a huge influx of investments from both professionals and members of the public who had to borrow vast sums to finance their speculations.
The stock market reached its peak on September 3 1929, when the Dow was sitting at 381.17. The crash would begin the following month on October 24, a day that is now known as Black Thursday. The market opened 11% down, and despite institutions stepping in to boost the market price, the relief was short lived. The following Monday, the Dow closed 13% down and fell a further 12% the next day. From peak to trough – on July 9 1932 – the Dow fell by 89.2%.
The aftermath of the crash caused ‘The Great Depression’, a worldwide economic depression that saw consumer spending and investment drop off and caused huge declines in industrial output and employment rates.
It took nearly three decades for the Dow to reach pre-crash levels.
2. Stock market crash 1987: Black Monday
In early October 1987, stock markets started to see small declines. Despite the mid-80s being a period of economic optimism, with indices globally having risen by nearly 300%, a culmination of factors resulted in the worst single day decline the world had ever seen at that point.
On Monday October 19 1987, a day now known as Black Monday, the crash started in Hong Kong, but quickly spread throughout Asia and Europe before hitting the US stock market. When the US market opened, stocks were already in freefall and by the end of the day, the Dow Jones had fallen by 22% - the worst single day decline in the Great Depression was 12%.
The cause of the crash is thought to be computer program-driven trading models focused on portfolio insurance. The strategy was thought to hedge a portfolio of stocks against market risk by short-selling index futures. But, as the programs automatically triggered at certain levels, prices were just pushed lower and lower as more stop-loss orders were set off. The same programs also stopped any buy orders from going out, which meant that there was no balance.
While these computer programs are thought to be the spark, it was panic selling from other investors that caused the worst of the decline. Other major indices had fallen by 20% by the end of the month.
The 1987 crash was the reason that trading curbs were introduced in most exchanges. The idea being that a period of shutdown would help stem the panic that sell-offs cause.
3. Stock market crash 2001: The Dot-Com Bubble
In the late 1990s, there was a huge rise in investment into technology companies fuelled by the growth of the internet. This bull market caused the Nasdaq composite to rise from 1,000 to more than 5,000 between 1995 and 2000. The companies’ shares were trading well above their true value, based purely on optimism that the companies would see huge amounts of success in the years to come. This period of speculation and over-inflated prices is now known as the ‘dot-com bubble.’
But what goes up – and is completely unfounded – must go down. The bubble burst in 2001 and caused a global bear market. The Nasdaq fell from its peak of 5,048.62 on March 10 2000 to a bottom of 1,139.90 on October 4 2002 – a decline of 78%.
Throughout this period, the majority of internet-based companies had cone bust. The few stocks that survived – the likes of Intel, Amazon, eBay and Cisco – still had huge chunks taken out of their market capitalisations. It took nearly 15 years for the Nasdaq to recover.
4. Stock market crash 2008: The Great Recession
In 2008, the Dow Jones fell by 777.68 points – the largest decline up until the Covid-19 crash in 2020. To understand the market crash, it’s important to take a look at the state of the US housing market in the years leading up to the decline.
In the early 2000s, banks were selling mortgages to individuals with very few checks – even people who had previously found finding a lender impossible due to poor credit history were able to buy houses for small initial payments.
This caused rising demand for mortgage-backed securities – essentially, these mortgages were repackaged and sold to investors as new financial products. Some of these securities were thought of as low risk, because they were insured. Investors initially profited as housing prices soared, but most investors didn’t understand the risks they were taking on.
In 2007, the housing market peaked and refinancing or selling homes became less viable. When homeowners defaulted on their loans, those invested in the market started to crash and burn. That year, New Century Financial Corp, a leading subprime mortgage lender, filed for bankruptcy, soon followed by a lot of other companies. The stock market crash started when the US Congress rejected a bailout bill.
In 2008, two government-sponsored enterprises, Fannie Mae and Freddie Mac, suffered large losses and were seized by the federal government. As foreclosures continued, the subprime mortgage market completely collapsed. This meant that other areas of the economy quickly fell like dominoes. Construction rates were plummeting, consumer spending and wealth fell, banks and other financial firms were unable to lend, and it became impossible raise funds from stock markets.
By March 5, 2009, the Dow Jones had dropped more than 50% to 6,594.44. While the 90% fall during the Great Depression happened over four years, the 2008 financial crisis took place over just 18 months. It took nearly six years for the market to recover.
5. Stock market crash 2010: The Flash Crash
The Flash Crash of 2010 is a markedly different type of financial crash than the others on our list because it lasted just 20 minutes. On May 6 2010, the day of a UK general election, mounting Greek debt and a volatile USD/JPY, the Dow Jones took a near 1,000-point nosedive.
While speculation as to the cause of the crash was rampant, within just a couple of days, US officials had pointed the finger at a $4.1 billion sell order from a mutual fund called Waddell & Reed. The mutual fund in question was using an automated algorithm strategy to trade E-Mini S&P contracts, and once the order was in, it sparked a sell-off from other high frequency traders.
For the most part, the stock market had managed to rebound in the same day, but while it lasted the flash crash erased almost $1 trillion in market value.
6. Stock market crash 2020: The Coronavirus Crash
As the global pandemic began to spread throughout the first few months of 2020, government officials began sending citizens into what would be the first of many lockdowns. The shutdown in economic activity led to a stock market crash in March 2020, that would include the three of the worst daily percentage declines in history.
On Monday March 9, the market fell by 7.79%, on March 12, the Dow fell by 9.99% and on March 16, the Dow fell by 12.9%. Each time, the drops were large enough that trading was suspended to try and stabilise the market. Between February 12 and March 23, the Dow lost 37% of its value.
Economies across the world went into lockdown mode, costing millions of individuals their jobs, closing down businesses and leading to an international death toll that had reached 4.55 million as of October 2021.
The stock market recovery from the coronavirus crash happened much quicker than anyone had imagined, especially given that the state of the economy was still dire. But thanks to fiscal stimulation, rescue packages and slashed interest rates, investors tentatively waded back into the markets. By August 2020, the S&P was hitting new record highs and by November, the Dow had returned to pre-pandemic levels and even passed the 30,000 mark for the first time.
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